The Capital Adequacy Ratio also abbreviated as CAR is the measurement of the bank’s available capital. This available capital is denoted as the percentage of the bank’s risk-weighted exposures to credit. It is used to protect the depositors and promote efficiency as well as the stability of the financial systems that are situated around the world. It is also known as the capital-to-risk weighted ratio. In CAR, two types of capital are measured. One is the tier-1 capital that can soak losses without a bank being needed to stop its trading. The second one is known as the tier-2 capital that can absorb losses in case a bank stops its services. This is the reason that the tier-2 capital is also known to provide a lesser degree of protection when compared to the tier-1 capital.
The Capital Adequacy Ratio Formula:
The Capital Adequacy Ratio is calculated by dividing the capital of the bank by its risk-weighted assets. Moreover, the capital used to calculate the CAR is usually divided into two tiers. Here is the formula of CAR.
CAR= Tier 1 Capital + Tier 2 Capital divided by Risk Weighted Assets
Tier 1 Capital:
The Tier-1 Capital is also known as the core capital. It also comprises of equity capital, ordinary share capital along with audited revenue reserves. It also has intangible assets. The tier-1 money is also used to absorb losses and does not require a bank to stop operations. Moreover, the tier-1 capital is also known as the capital that is readily available and is permanent. An excellent example of the bank’s tier-1 capital is the ordinary share capital.
It is important here to note that the tier-2 capital comprises of unaudited retained earnings coupled with general loss reserves and unaudited reserves. It is also known as the cushion that absorbs the losses in case the bank is stopping its operation. Moreover, it provides a lesser degree of protection to depositors and creditors. The bank loses its tier-1 capital; the tier-2 money comes to the fore.
The capital mentioned above tiers are supplemented together and are divided by the risk-weighted assets to calculate the bank’s adequacy ratio. Interestingly, the risk-weighted assets are calculated by looking at the bank’s loans. On the other hand, when measuring the credit exposures, adjustments are usually made to the value of the assets that are listed on the balance sheet of the lender.
The weighted risk assets are a way to find the minimum amount of capital that must be occupied by banks and other financial institutions so that they can minimize the risk of insolvency. It is important here to note that capital requirement is based on the risk assessment for each type of bank. For instance, a loan that is secured by a credit letter is considered to be riskier as it needs more capital when compared to a mortgage loan.
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Calculations with Examples of CAR:
- Let’s cite an example of CAR in this context. Suppose Bank XYZ has 10 million dollars in tier-1 capital and 5 million dollars in tier-2 money.
- It has loans that should be weighted and calculated to a total of 50 million dollars.
- The capital adequacy ratio of the bank is around 30%.
- 10 million dollars plus 5 million dollars divided by 50 million dollars.
- Therefore, this bank would have a higher CAR and is considered to be safer.
- As a result, bank XYZ would have fewer chances that it would become insolvent if unexpected losses occur.
What is the Importance of the CAR?
- The reason that the CAR is essential lies in the fact that they are critical to ensure that banks have enough cushion to absorb the losses before they become insolvent and lose the funds of the depositors.
- Moreover, the CAR plays a deciding role in enhancing the financial security of a nation. It lowers the risk of insolvency in banks.
- Hence, a bank that has high CAR is more likely to perform better and would meet all its financial obligations as set out in its agenda.
- On the other hand, during the process of winding up of a bank’s operations, the funds that belong to the depositor are always given a high priority than the capital of the bank.
- Hence, the depositors can only lose their savings in case the bank registers a slump in its performance.
- If the bank has a higher CAR, then the degree of protection would be higher for the assets of the depositor.
Solvency Ratio when Compared to CAR:
It is important here to note that the CAR and the solvency ratio provide various ways to assess the debt of the company when compared to the revenue situation of the bank. However, CAR is usually applied mainly to the evaluating banks. The solvency ratio metric can also be used for the assessment of any company.
Solvency ratio below 20% usually indicates that there is an increasing likelihood of default. It is crucial here to mention that analysts often favor the solvency ratio for facilitating an inclusive rate of the financial solution of a particular organization.
The solvency ratio is best applied in comparison with similar firms that are in the same industry. It is so because specific industries tend to be in more debt-heavy when compared to the others.
From the above-discussed points, it is quite clear that CAR is critical to the performance of a bank. It provides the bank with a proper cushion so that it can absorb losses. Regulators also use it in a bid to determine the required capital adequacy for banks. It also helps banks and financial institutions to run stress tests.
Tier-1 capital is the more popular one when compared to the Tier-2 money as it absorbs a reasonable amount of loss without forcing the bank to stop its operations. On the other hand, the tier-2 money can sustain a loss even during liquidation periods. Hence, both these tiers are beneficial in case of financial loss.